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Portugal aid could ease spreading crisis

Apr 07 2011 09:55

Reuters

Berlin - Portugal's decision to seek international aid removes a cloud of uncertainty over the eurozone and has a good chance of ending the spread of debt market crises to fresh countries in the region.

Investors had believed for months that a bailout for Portugal was almost inevitable, so the announcement by caretaker Prime Minister Jose Socrates on Wednesday is unlikely to hurt financial markets. The euro barely moved in the initial hours after the announcement.

The expected size of the bailout, €60bn - €80bn according to a senior eurozone source, will not strain the eurozone's €440bn bailout fund, especially since the International Monetary Fund is likely to be involved. Based on past bailouts, it would contribute about a third of the amount.

Many investors will see the request for aid as positive since it promises to avoid a worst-case scenario in which Portugal would have limped along under a minority government until general elections scheduled for June 5, refusing to seek help and digging an ever-bigger economic hole for itself.

This would have continued to push up Portuguese bond yields and threatened a collapse of its finances that might have prompted markets to start attacking Spain, widely seen as the next potential domino in the eurozone.

Other governments in the zone have therefore been pressing Portugal to request a bailout, and Lisbon's willingness to comply - despite its bad memories of IMF-ordered austerity in the 1980s - suggests the region remains able to summon enough political unity to address its debt problems.

"This is good news. We've been saying for a while that Portugal's finances were not sustainable at these rates," Erik Nielsen, chief European economist at Goldman Sachs, told Reuters. "We think the contagion stops here."

Spain

As recently as the turn of the year, it seemed likely that markets would target Spain if Portugal followed Greece and Ireland in seeking a bailout.

But the government of Spanish Prime Minister Jose Luis Rodriguez Zapatero has unveiled a series of reforms of the labour market, pensions and banking sector in past months. A stabilisation of Spanish bond spreads shows many investors now believe it can avoid the fate of its smaller neighbour.

Portugal will have to agree to tough austerity targets to obtain a bailout, and how quickly a deal can be negotiated is unclear. Socrates resigned abruptly last month after his latest package of austerity measures was voted down in parliament, and his caretaker government has said it lacks the authority to negotiate an economic adjustment programme.

European Union officials may also be loath to pursue an agreement before a new government emerges in the aftermath of the June 5 elections. In the case of Ireland, the EU sealed a bailout deal with a lame duck administration only to face demands for changes from a new government in Dublin.

However, now that it is requesting aid, Portugal has much better prospects of obtaining some kind of bridging loan if that is necessary to tide it over until a full bailout deal.

And unlike Ireland, where crumbling banks have been a black hole for state funds, and Greece, which is struggling against ingrained tax evasion and corruption, Portugal may be a relatively straightforward case for the EU and the IMF.

The country already has an austerity plan in place which has received the blessing of EU governments and IMF officials.

Also, Europe has learned lessons from the two previous bailouts. There is now a broad consensus in policymaking circles that the rescue terms for Greece and Ireland were too onerous, straining their economies and finances, so Portugal can hope to get somewhat softer terms in some areas.

"Investors no longer seem to be worried about a full-blown eurozone crisis and the potential demise of the common currency because they assume mechanisms are now in place to prevent the crisis from escalating out of control," said Jane Caron, chief economic strategist at US firm Dwight Asset Management.

Debt, bank risks

Still, while a Portuguese bailout may end the geographical spread of sovereign debt problems in the eurozone, it will not remove two big risks faced by the weakest countries: the possibility of sovereign debt restructurings, and the threat of deeper problems in the banking sector.

Some senior government officials in the zone are now acknowledging for the first time in private that some form of debt restructuring for Greece may be inevitable, even though officials publicly deny it will happen.

A number of economists believes the same fate may await Ireland and Portugal, although probably at a later date.

Those fears are likely to keep market interest rates in all three countries very high for years, even if the countries do carry out the economic and fiscal reforms demanded by the EU and the IMF.

Joao Leite, head of investment at Banco Carregosa in Lisbon, said international aid would solve Portugal's financing problems but that the country still faced a daunting task addressing its large deficits, competitiveness problems and weak growth.

"Unfortunately, the solutions to these problems will only have an impact over the longer term. Until then the Portuguese have a hard road ahead."

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